Taxpayer Entitled to Charitable Deduction for Gifts of LLC Units

The Ninth Circuit held that a taxpayer
was entitled to a charitable deduction for gifts of LLC
units to two charitable foundations that were transferred
to the foundations when the IRS increased the value of the
LLC units on audit.

Background

After Anne Petter inherited a large amount of UPS
stock, she set up a complex estate plan designed to give
some of her wealth to charity and as much of her stock
as she could to two of her children, Donna and Terry,
without having to pay gift tax. As part of the plan,
Petter transferred the stock to a family LLC in return
for interests in the LLC, and she set up separate trusts
for both Donna and Terry. Petter transferred membership
units in a family-owned LLC partly as a gift and partly
by sale to the two trusts and coupled the transfers with
simultaneous gifts of LLC units to two charitable
foundations. The transfer agreements
included:

A dollar formula clause,
which assigned to the trusts a number of LLC units worth
a specified dollar amount and assigned the remainder of
the units to the foundations; and

A
reallocation clause, which obligated the trusts to
transfer additional units to the foundations if the
value of the units the trusts initially received was
finally determined for federal gift tax purposes to
exceed the specified dollar amount.

Petter filed a gift tax return to report the
transfers in 2002. The return disclosed the allocation
and reallocation clauses. It further disclosed that the
value of the LLC for determining the amount of the
transfers reported was based on the fair market value of
the underlying assets of the LLC with a 46%
nonmarketability discount and a 13.3% net asset value
adjustment applied.

On audit in 2005, the IRS concluded that the LLC
units had been greatly undervalued. Petter and the IRS
eventually agreed that the value of the LLC units was
slightly lower than the amount the IRS initially
claimed. Under the transfer agreements, this resulted in
the transfer of additional LLC units from the trusts to
the charitable foundations.

Petter sought
to take a deduction for the additional shares given to the
charitable foundations. However, the IRS refused to allow
her to take the deduction, claiming that the dollar
formula clauses were void as against public policy, and
the clauses caused the gifts to be subject to a condition
precedent under Regs. Sec. 25.2522(c)-3. Petter challenged
the IRS’s determination in Tax Court, which held that the
transfers were not void as against public policy and were
not gifts subject to a condition precedent (Estate of Petter,
T.C. Memo. 2009-280).

The IRS appealed the decision to the Ninth Circuit,
where it abandoned the public policy theory and argued
only that the adjustment feature of the dollar formula
clauses made the additional gifts subject to a condition
precedent as described in Regs. Sec.
25.2522(c)-3(b)(1):

If, as of the date of the
gift, a transfer for charitable purposes is dependent upon
the performance of some act or of the happening of a
precedent event in order that it might become effective,
no deduction is allowable unless the possibility that the
charitable transfer will not become effective is so remote
as to be negligible.

The Ninth
Circuit’s Decision

The Ninth Circuit held that Petter was entitled to a
charitable deduction for the transfer of the additional
units to the charitable foundations because the formula
clauses spoke only to the value of the LLC units, not to
whether the foundations were entitled to receive a
specific number of units at the time of the gift. Thus,
the additional transfer of LLC units to the foundations
was not subject to a condition precedent within the
meaning of Regs. Sec. 25.2522(c)-3(b)(1).

According to the Ninth Circuit, under the terms of
the transfer agreements, the foundations were always
entitled to receive a predefined number of units, which
the documents essentially expressed as a mathematical
formula. This formula had one unknown: the value of an
LLC unit at the time the transfer agreements were
executed. But though unknown, that value was a constant,
which meant that both before and after the IRS audit,
the foundations were entitled to receive the same number
of units. Absent the audit, the foundations might never
have received all the units they were entitled to, but
that did not mean that part of Petter’s transfer
depended upon an IRS audit. Rather, the audit merely
ensured that the foundations would receive the units
they were always entitled to receive.

Reflections

The IRS lost on the condition-precedent issue in a
similar case, Estate of Christiansen, 586 F.3d 1061 (8th Cir. 2009), which the Ninth
Circuit discussed at some length in Petter. The Ninth Circuit expressed its certainty in the
correctness of its decision by inviting the IRS to amend
the regulations if it did not like the results of the
case.

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